Recession risk rises as Iran tensions and US-China trade war build

Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.

Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:

“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:

• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily

• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”

In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.

Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:

  • One set of worries focuses on potential supply disruption from a war in the Middle East
  • The other agonises over the US-China trade war and the rising risk of recession

It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.

The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:

“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”

But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.

Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession.  The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.

The reason is that consumers only have a certain amount of discretionary income.  If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.

“To govern is to choose” and President Trump therefore has some hard choices ahead:

  • His trade war with China currently appeals to many voters, Democrat and Republican.  But will that support continue as the costs bite?  The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
  • Similarly, many voters favour taking a hard line with Iran.  But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters

History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent.  Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.

Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out.  Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.

Déjà vu all over again for oil markets as recession risks rise

Back in 2015, veteran Saudi Oil Minister Ali  Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4.  But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand.  And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.

Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:

  • Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
  • But its short-term need is to support prices by cutting production, in order to fund its spending priorities

The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past.  It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.

The reason is that high oil prices reduce discretionary spending.  Consumers have to drive to work and keep their homes warm (and cool in the summer).  So if oil prices are high, they have to cut back in other areas, slowing the economy.

CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014

There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.

They were creating tens of $tns of free cash to support consumer spending.  But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report.  It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:

“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.

SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS

Oil prices are therefore now on a roller-coaster ride:

  • Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
  • The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December

Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).  But as always, its “allies” have let it down.  So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.

Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:

Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds.  As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.

But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.

Companies and investors therefore need to be very cautious.  Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.

Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.

 

*Total cost is number of barrels used multiplied by their cost

Oil prices flag recession risk as Iranian geopolitical tensions rise

Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same.  Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.

The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story.  So the chart above instead combines 5 “shock, horror”  stories, showing quarterly oil production since 2015:

  • Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015.  OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
  • Russia has also been much in the news since joining the OPEC output agreement in November 2016.  But in reality, it has done little.  Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
  • Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
  • Venezuela is an OPEC member, but its production decline began long before the OPEC deal.  The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
  • The USA, along with Iran, has been the big winner over the past 2 years.  Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!

But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April.  Not much “shock, horror” there over a 3 year period.  More a New Normal story of “Winners and Losers”.

So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday?  Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble.  The answer lies in the second chart from John Kemp at Reuters:

  • It shows combined speculative purchases in futures markets by hedge funds since 2013
  • These hit a low of around 200mbbls in January 2016 (2 days supply)
  • They then more than trebled to around 700mbbls by December 2016 (7 days supply)
  • After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)

Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently:  “Several of them had little or no experience or even a basic understanding of how the physical market works.”

This critical point is confirmed by Citi analyst Ed Morse:  “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.

Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:

“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).

OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION

The hedge funds have been the real winners from all the “shock, horror” stories.  These created the essential changes in “crowd behaviour”, from which they could profit.  But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:

  • Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
  • This level has been linked with a US recession on almost every occasion since 1970
  • The only exception was post-2009 when China and the Western central banks ramped up stimulus
  • The stimulus simply created a debt-financed bubble

The reason is simple.  People only have so much cash to spend.  If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy.  Chemical markets are already confirming that demand destruction is taking place.:

  • Companies have completely failed to pass through today’s high energy costs.  For example:
  • European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
  • They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)

Even worse news may be around the corner.  Last week saw President Trump decide to withdraw from the Iran deal.  His daughter also opened the new US embassy to Jerusalem.  Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.

As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities.  Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz.  It is just 21 miles wide (34km)  at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.

As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”.  Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets.  We must all learn to form our own judgments about the real risks that might lie ahead.

 

Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.

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Saudi oil policy risks creating perfect storm for Aramco flotation

Good business strategies generally create good investments over the longer term. And so Aramco needs to ensure it has the best possible strategies, if it wants to maximise the outcome from its planned $2tn flotation. Unfortunately, the current oil price strategy seems more likely to damage its valuation, by being based on 3 questionable assumptions:

  • Oil demand will always grow at levels seen in the past – if transport demand slows, plastics will take over
  • Saudi will always be able to control the oil market – Russian/US production growth is irrelevant
  • The rise of sustainability concerns, and alternative energy sources such as solar and wind, can be ignored

These are dangerous assumptions to make today, with the BabyBoomer-led SuperCycle fast receding into history.

After all, even in the SuperCycle, OPEC’s attempt in the early 1980s to hold the oil price at around today’s levels (in $2018) was a complete failure.  So the odds on the policy working today are not very high, as Crown Prince Mohammed bin Salman (MbS) himself acknowledged 2 years ago, when launching his ambitious ‘Vision 2030:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil.  We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

As I noted here at the time, MbS’s bold plan for restructuring the economy included a welcome dose of reality:

“The government’s new Vision statement is based on the assumption of a $30/bbl oil price in 2030 – in line with the long-term historical average. And one key element of this policy is the flotation of 5% of Saudi Aramco, the world’s largest oil company. Estimates suggest it is worth at least $2tn, meaning that 5% will be worth $100bn. And as I suggested to the Wall Street Journal:

“The process of listing will completely change the character of the company and demand a new openness from its senior management“.

MbS is still making good progress with his domestic policy reforms.  Women, for example, are finally due to be allowed to drive in June and modern entertainment facilities such as cinemas are now being allowed again after a 35 year ban.  But unfortunately, over the past 2 years, Saudi oil policy has gone backwards.

SUSTAINABILITY/RENEWABLES ARE ALREADY REDUCING OIL MARKET DEMAND

Restructuring the Saudi economy away from oil-dependence was always going to be a tough challenge.  And the pace of the required change is increasing, as the world’s consumers focus on sustainability and pollution.

It is, of course, easy to miss this trend if your advisers only listen to bonus-hungry investment bankers, or OPEC leaders.  But when brand-owners such as Coca-Cola talk, you can’t afford to ignore what they are saying – and doing.

Coke uses 120bn bottles a year and as its CEO noted when introducing their new policy:

“If left unchecked, plastic waste will slowly choke our oceans and waterways.  We’re using up our earth as if there’s another one on the shelf just waiting to be opened . . . companies have to do their part by making sure their packaging is actually recyclable.”

Similarly, MbS’s advisers seem to be completely ignoring the likely implications of China’s ‘War on Pollution’ for oil demand – and China is its largest customer for oil/plastics exports.

Already the European Union has set out plans to ensureAll plastic packaging is reusable or recyclable in a cost-effective manner by 2030”.

And in China, the city of Shenzhen has converted all of its 16359 buses to run on electric power, and is now converting its 17000 taxis.

Whilst the city of Jinan is planning a network of “intelligent highways” as the video in this Bloomberg report shows, which will use solar panels to charge the batteries of autonomous vehicles as they drive along.

ALIENATING CONSUMERS IS THE WRONG POLICY TO PURSUE
As the chart at the top confirms, oil’s period of energy dominance was already coming to an end, even before the issues of sustainability and pollution really began to emerge as constraints on demand.

This is why MbS was right to aim to move the Saudi economy away from its dependence on oil within 20 years.

By going back on this strategy, Saudi is storing up major problems for the planned Aramco flotation:

  • Of course it is easy to force through price rises in the short-term via production cuts
  • But in the medium term, they upset consumers and so hasten the decline in oil demand and Saudi’s market share
  • It is much easier to fund the development of new technologies such as solar and wind when oil prices are high
  • It is also much easier for rival oil producers, such as US frackers, to fund the growth of new low-cost production

Aramco is making major strides towards becoming a more open company.  But when it comes to the flotation, investors are going to look carefully at the real outlook for oil demand in the critical transport sector.  And they are rightly going to be nervous over the medium/longer-term prospects.

They are also going to be very sceptical about the idea that plastics can replace lost demand in the transport sector.  Already 11 major brands, including Coke, Unilever, Wal-Mart  and Pepsi – responsible for 6 million tonnes of plastic packaging – are committed to using “100% reusable, recyclable or compostable packaging by 2025“.

We can be sure that these numbers will grow dramatically over the next few years.  Recycled plastic, not virgin product, is set to be the growth product of the future.

ITS NOT TOO LATE FOR A RETURN TO MBS’s ORIGINAL POLICY
Saudi already has a major challenge ahead in transforming its economy away from oil.  In the short-term:

  • Higher oil prices may allow the Kingdom to continue with generous handouts to the population
  • But they will reduce Aramco’s value to investors over the medium and longer-term
  • The planned $100bn windfall from the proposed $2tn valuation will become more difficult to achieve

3 years ago, Saudi’s then Oil Minister was very clear about the need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”

As philosopher George Santayana wisely noted, “Those who cannot remember the past are condemned to repeat it.”

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Economy faces slowdown as oil/commodity prices slide


Oil and commodity markets long ago lost contact with the real world of supply and demand. Instead, they have been dominated by financial speculation, fuelled by the vast amounts of liquidity pumped out by the central banks.  The chart above from John Kemp at Reuters gives the speculative positioning in the oil complex as published last Monday:

  • It shows hedge fund positioning in terms of the ratio of long to short positions across the complex
  • The ratio had been at a near-record low of 1.55x back in June last year, before the rally took off
  • On 30 January it had risen to a record 11.9x – far above even the 2014 and 2017 peaks

The size of the rally has also been extraordinary, as I noted 2 weeks ago.  At its peak, the funds owned 1.5bn barrels of oil and products – equivalent to an astonishing 16 days of global oil demand.  They had bought 1.2bn barrels since June, creating the illusion of very strong demand.  But, of course, hedge funds don’t actually use oil, they only trade it.

The funds also don’t normally hang around when the selling starts. And so last week, as the second chart shows, they began to sell their positions and take profits.  The rally peaked at $71/bbl at the end of January, and then topped out on 2 February at $70/bbl.  By last Friday, only a week later, Brent was at $63/bbl, having fallen 11% in just one week.

Of course, nothing had changed in the outlook for supply/demand, or for the global economy, during the week.  And this simple fact confirms how the speculative cash has come to dominate real-world markets.  The selling was due to nervous traders, who could see prices were challenging a critical “technical” point on the chart:

  • Most commodity trading is done in relation to charts, as it is momentum-based
  • The 200 day exponential moving average (EMA) is used to chart the trend’s strength
  • When the oil price reached the 200-day EMA (red line), many traders got nervous
  • And as they began to sell, so others began to follow them as momentum switched

The main sellers were the legal highwaymen, otherwise known as the high-frequency traders.  Their algorithm-based machines do more than half of all daily trading, and simply want a trend to follow, milli-second by milli-second.  As the Financial Times warned in June:

“The stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists.”

JP Morgan even estimates that only 10% of all trading is done by “real investors”:

“Passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago, and reckons that only roughly 10% of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.”

Probably prices will now attempt to stabilise again before resuming their downward movement.  But clearly the upward trend, which took prices up by 60% since June, has been broken.  Similar collapses have occurred across the commodity complex, with the CRB Index showing a 6% price fall across major commodities:

  • Typically, inventory build ahead of price rises can add an extra month of “apparent demand” to real demand
  • This inventory will now have to be run down as buyers destock to more normal levels again
  • This means we can expect demand to slow along all the major value chains
  • Western companies will now see slow demand through Easter: Asia will see slow demand after Lunar New Year

This disappointment will end the myth that the world is in the middle of a synchronised global recovery. In turn, it will cause estimates of oil demand growth to be reduced, further weakening prices.  It will also cause markets to re-examine current myths about the costs of US shale oil production:

  • As the charts from Pioneer Natural Resources confirm, most shale oil breakeven costs are below $30/bbl
  • Pioneer’s own operating costs, typical of most of the major players, are below $10/bbl
  • So the belief that shale oil needs a price of $50/bbl to support future production is simply wrong

PREPARE FOR PROFIT WARNINGS AND POTENTIAL BANKRUPTCIES BY THE SUMMER
Over the summer, therefore, many industrial companies will likely need to start issuing profit warnings, as it becomes clear that demand has failed meet expectations.  This will put stock markets under major pressure, especially if interest rates keep rising as I discussed last month.

Smart CEOs will now start to prepare contingency plans, in case this should happen.  We can all hope the recent downturn in global financial markets is just a blip.  But hope is not a strategy.  And the risk of profit warnings turning into major bankruptcies is extremely high, given that global debt now totals $233tn, more than 3x global GDP.

 

FORECAST MONITORING
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.

Since January, I have also been monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. Today’s forecast for oil prices to fall initially to $50/bbl is therefore now added to those on ethylene/polyethylene and the US 10-year interest rate. I am also increasing the confidence level for the interest rate forecast to 70%, and will continue to update these levels when circumstances change.

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Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear

Saudi Arabia’s U-turn to revive oil output quotas is not working and fails to address the changing future of oil demand, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Saudi Arabia’s move into recession comes at an unfortunate time for its new Crown Prince, Mohammed bin Salman (known to all as MbS).

Unemployment is continuing to rise, threatening the social contract. In foreign affairs, the war in Yemen and the dispute with Qatar appear to be in stalemate. And then there is the vexed issue of King Salman’s ill health, and the question of who succeeds him.

This was probably not the situation that the then Deputy Crown Prince envisaged 18 months ago when he launched his ambitious “Vision 2030” programme and set out his hopes for a Saudi Arabia that was no longer dependent on oil revenues. “Within 20 years, we will be an economy that doesn’t depend mainly on oil . . . We don’t care about oil prices — $30 or $70, they are all the same to us. This battle is not my battle.”

The problems began a few months later after he abruptly reversed course and overturned former oil minister Ali al-Naimi’s market share policy by signing up to repeat the failed Opec quota policy of the early 1980s.

His hope was that by including Russia, the new deal would “rebalance” oil markets and establish a $50 a barrel floor under prices. In turn, this would boost the prospects for his proposed flotation of a 5 per cent stake in Saudi Aramco, with its world record target valuation of $2tn.


But, as the chart above shows, the volte face also handed a second life to US shale producers, particularly in the Permian basin, which has the potential to become the world’s largest oilfield. Its development had been effectively curtailed by Mr Naimi’s policy.

The number of high-performing horizontal drilling rigs had peaked at 353 in December 2014. By May 2016, the figure had collapsed to just 116. But since then, the rig count has trebled and is close to a new peak, at 336, according to the Baker Hughes Rig Count.

Even worse from the Saudi perspective is that oil production per Permian rig has continued to rise from December 2014’s level of 219 barrels a day. Volume has nearly trebled to 572 b/d, while the number of DUC (drilled but uncompleted) wells has almost doubled from 1,204 to 2,330.


Equally disturbing, as the second chart from Anjli Raval’s recent FT analysis confirms, is that Saudi Arabia has been forced to take the main burden of the promised cutbacks. Its 519,000 b/d cut almost exactly matches Opec’s total 517,000 b/d cutback.

Of course, other Opec members will continue to cheer on Saudi Arabia because they gain the benefit of higher prices from its output curbs.

But we would question whether the quota strategy is really the right policy for the Kingdom itself. A year ago, after all, Opec had forecast that its new quotas would “rebalance the oil market” in the first half of this year. When this proved over-optimistic, it expected rebalancing to have been achieved by March 2018. Now, it is suggesting that rebalancing may take until the end of 2018, and could even require further output cuts.

Producers used to shrug off this development, arguing that demand growth in China, India and other emerging markets would secure oil’s future. But they can no longer ignore rising concerns over pollution from gasoline and diesel-powered cars.

India has already announced that all new cars will be powered by electricity by 2030, while China is studying a similar move. China has a dual incentive for such a policy because it would not only support President Xi Jinping’s anti-pollution strategy, but also create an opportunity for its automakers to take a global lead in electric vehicle production.

It therefore seems timely for Prince Mohammed to revert to his earlier approach to the oil price. The rebalancing strategy has clearly not produced the expected results and, even worse, US shale producers are now enthusiastically ramping up production at Saudi Arabia’s expense.

The kingdom’s exports of crude oil to the US fell to just 795,000 b/d in July, while US oil and product exports last week hit a new record level of more than 7.6m b/d, further reducing Saudi Arabia’s market share in key global markets.

The growing likelihood that oil demand will peak within the next decade highlights how Saudi Arabia is effectively now in a battle to monetise its reserves before demand starts to slip away.

Geopolitics also suggests that a pivot away from Russia to China might be opportune. The Opec deal clearly made sense for Russia in the short term, given its continuing dependence on oil revenues. But Russia is never likely to become a true strategic partner for the kingdom, given its competitive position as a major oil and gas producer, and its longstanding regional alliances with Iran and Syria. China, however, offers the potential for a much more strategic relationship, which would allow Saudi Arabia as the world’s largest oil producer to boost its sales to the world’s second-largest oil market.

China also offers a potential solution to the vexed question of the Saudi Aramco flotation, following the recent offer by an unnamed (but no doubt state-linked) Chinese buyer to purchase the whole 5 per cent stake. This would allow Prince Mohammed to avoid embarrassment by claiming victory in the sale while avoiding the difficulties of a public float.

The Chinese option would also help the kingdom access the One Belt, One Road (OBOR) market for its future non-oil production. This option could be very valuable, given that OBOR may well become the largest free-trade area in the world, as we discussed here in June.

In addition, and perhaps most importantly from Prince Mohammed’s viewpoint, the China pivot might well tip the balance within Saudi Arabia’s Allegiance Council, and smooth his path to the throne as King Salman’s successor.

Paul Hodges and David Hughes publish The pH Report.

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